Index entry alone doesn't make a stock attractive

There are stocks, and then there are index stocks. That is why when a stock is included in or excluded from an important index such as the Nifty, Sensex or the MSCI (Morgan Stanley Capital International), it attracts the attention of both domestic and foreign investors.

This is primarily because many portfolios and funds are benchmarked to these indices. And the juggling of index stocks happens quite a bit. For example, when the MSCI India Index was revamped in May 2012, Bank of Baroda, Godrej Consumer Products and Cairn India made an entry, while Suzlon Energy was chucked out of the index.

Naturally, investors take a fancy to the stocks that made an entry into an index. For example, the stock price of Bank of Baroda moved up from Rs 687 to Rs 720 in a week's time after its inclusion in the MSCI India Index.

However, experts warn against making the inclusion or exclusion of stocks into an index as the sole basis of buying or selling decisions.

"A stock could be included in a particular index based on parameters like free float, liquidity and market capitalisation, besides other qualitative factors. It may not take into account things like future potential of the industry or its valuations," says Manish Bandi, fund manager, India Infoline Asset Management Company.

"Prices could move up or down in the short term. Investors need to take a hard look at valuations, future potential of the industry and investment time horizon before they take a decision on buying a stock," says Dipen Shah, head of fundamental research at Kotak Securities.

Ignore short-term movements

Stocks which are included in an index tend to move up in the short term because many institutional investors or index funds that mimic the index start buying that stock to update their portfolios. For example, if a stock that is included has a weight of 2% in the Nifty, it will witness purchases worth $200 million (approximately Rs 1,100 crore) if funds worth $10 billion are benchmarked to the index.

Consider Asian Paints which was included in the Nifty on April 27. On the previous day (April 26), the stock was quoting at Rs 3,483, but it rose to Rs 3,770 in a fortnight, a gain of 8%. You will get the real picture when you consider the slide in the Sensex during the same period. The benchmark index fell 1% to 16,968 in the same fortnight.

Get the big picture

"There are a number of qualitative and quantitative factors considered by the index committee before a stock is included or excluded from an index," says Alok Churiwala, managing director, Churiwala Securities.

For example, there are times a stock gets listed and automatically gets included in the index because the industry is unrepresented, or because the market capitalisation of the stock is really large. For example, DLF, from the real estate space, was included in the index in March 2008.

GlaxoSmithKline Pharma was excluded from the Nifty to accommodate DLF. You have to notice that the move didn't mean that Glaxo is a bad investment bet or DLF is a good investment bet. The share price movements make it clear. DLFs price has corrected from Rs 646 in March 2008 to Rs 194 in June 2012, while GlaxoSmithKline Pharma's price has doubled from Rs 1,040 to 2001 during the same period. There are many such examples.

In March 2008, Bajaj Auto was dropped from the Nifty to accommodate Power Grid. However, the departure from the index did not have any impact on the financial performance of the company. Its sales moved up from Rs 8,660 crore in March 2008 to Rs 19,528 crore in March 2012.

Net profit also increased from Rs 315 crore to Rs 755 crore during the same period. Naturally, the stock was rewarded handsomely: the stock price moved up from 300 in March 2008 to 1,560 in June 2012.

That is why experts believe that long-term investors should pay more attention to the fundamental factors and valuations of a stock rather than its entry or exit from a particular index. "Investors should look at the financial performance of the company, the rate at which it is growing, valuations and the management pedigree while investing in a stock," says Dipen Shah.